Friday: Financial Restructuring
Cap des
Biches
AshantiBogoso
Feng-Shui
Copyright ©2003 Ian H. Giddy
Financial Restructuring 1
Mt Cameroon
Ecotours
Copyright ©2003 Ian H. Giddy
Financial Restructuring 2
Mt Cameroon
Mount Cameroon Ecotours
Last Year
Tourists
Revenue/Tourist
Revenues
Expenses
Profit
Capex
Working Cap
Free cash flows:
Expected Return
Terminal Value
PV (Cashflows)
NPV
Cash
Firm Value
Equity to Raise
Equity to Firm
Copyright ©2003 Ian H. Giddy
700
0.65
455.00
(305.00)
150.00
12,357
1,300
13,657
5,000
8,657
Year 1
Year 2
Year 3
Year 4
850
0.65
552.50
(442.50)
110.00
(2,100.00)
(500.00)
(2,490.00)
935
0.65
607.75
(463.75)
144.00
1,100.00
(50.00)
1,194.00
2,550
2,805
3,086
1.30
1.30
1.30
3,315.00 3,646.50 4,011.15
(867.50) (931.25) (1,001.38)
2,447.50 2,715.25 3,009.78
25%
25%
25%
(1,992.00)
764.16
1,224.96
(55.00)
(55.50)
2,392.50 2,659.75
Year 5
Terminal
3,240
1.30
4,211.71
(1,039.94)
3,171.76
(55.55)
2,954.23
(27.78)
3,143.99
25%
25%
1,089.43
968.04
15%
31,439.86
10,302.21
= 5,000 - 2,200 - 1,000 -500
37% Percentage of equity to investors
63% Percentage of equity to owners
Financial Restructuring 3
Leveraged Finance
Cost of the Deal
Estimating cost of deal
Shares
Price
Premium
Equity cost
Debt cost
Fees
Capex & restructuring
Total cost of deal
$
$
5% $
10% $
$
10
45
15%
518
$ 55
29
57
658
lbocapacity.xls
Copyright ©2003 Ian H. Giddy
Financial Restructuring 5
LBO Financing
NEWCO
Cost of
purchasing
the
business
Copyright ©2003 Ian H. Giddy
Senior
debt $457
Mezzanine
What securities?
What returns?
What investors?
Equity $25
Financial Restructuring 6
Case Study: Cap des Biches (B)
The LBO Proposal
 Devise a recommended financing plan

GTI (owner)
Buyers
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Other Investors
Financial Restructuring 7
Cap des Biches (B)
Cap des Biches (B)
Evaluating a Leveraged Buy-Out (LBO)
Given
Share price
Number of shares
GTI ownership
Public ownership
NOI
Interest
Coverage
Tax
Earnings
Per share
Growth rate
30%
LBO data
Management equity
Bank coverage ratio needed
Bank rate
Seller's debt amount
Seller's debt rate
Premium for shares
Sale NOI multiple
24
9 million
35%
65%
30.00
1.00
30.00
8.70
20.30
2.26
3.60%
Acquisition data
Flexics P/E
Free cash flows next year
Free cash flows last year
Raise growth to
Upfront costs
18
10.64
$2.57 per share
$2.48 per share
5.50%
$2.00 per share
20
2
12%
30
15%
5% assumption
12
www.stern.nyu.edu/~igiddy/dakar
Copyright ©2003 Ian H. Giddy
Financial Restructuring 8
Corporate
Financial Restructuring
Prof. Ian GIDDY
Stern School of Business
New York University
What is Corporate Restructuring?
Any substantial change in a company’s
financial structure, or ownership or
control, or business portfolio.
 Designed to increase the value of the
firm
Restructuring

Improve
capitalization
Copyright ©2003 Ian H. Giddy
Improve
debt composition
Change ownership
and control
Financial Restructuring 10
It’s All About Value

How can corporate and financial
restructuring create value?
Assets
Fix the
business
Copyright ©2003 Ian H. Giddy
Operating
Cash
Flows
Liabilities
Debt
Or fix the
financing
Equity
Financial Restructuring 11
Restructuring
Figure out what the business is
worth now
Use valuation model – present value
of free cash flows
Fix the business mix – divestitures
Value assets to be sold
Fix the business – strategic partner
or merger
Value the merged firm with
synergies
Fix the financing – improve D/E
structure
Revalue firm under different
leverage assumptions – lowest
WACC
Fix the kind of equity
What can be done to make the
equity more valuable to investors?
Fix the kind of debt or hybrid
financing
What mix of debt is best suited to
this business?
Fix management or control
Value the changes new control
would produce
Copyright ©2003 Ian H. Giddy
Financial Restructuring 12
Corporate Finance
CORPORATE FINANCE
DECISONS
INVESTMENT
FINANCING
PORTFOLIO
RISK MGT
MEASUREMENT
CAPITAL
DEBT
M&A
Copyright ©2003 Ian H. Giddy
EQUITY
TOOLS
Financial Restructuring 13
Capital Structure: East vs West
Intel
VALUE
OFTHE
FIRM
TPI
Optimal debt ratio?
DEBT
RATIO
Copyright ©2003 Ian H. Giddy
Financial Restructuring 14
Fixing the Capital Structure
Too little debt
 Managers like to control
shareholders’ funds
 Underestimate the cost
of equity
Produces
 Less discipline
 Excessive cost of
capital
 Takeover risk
Copyright ©2003 Ian H. Giddy
Too much debt
 Close control of equity
 Easy money
 Underestimate business
or financial risks
Produces
 Risk of financial distress
 Excessive cost of
capital
 Destroy operating value
 Takeover risk
Financial Restructuring 15
Fixing the Capital Structure:
Distress Restructuring
The Three Excesses
Labor
 Capacity
 Debt

Copyright ©2003 Ian H. Giddy
Financial Restructuring 17
TPI’s Refinancing
Asia’s biggest debtor
 Almost $4 billion in foreign currency
debt financing domestic revenues
 Protracted rescheduling results in $360
million debt/equity swap
 No change in management or effective
control
 Still needs $1.2 billion new equity

Copyright ©2003 Ian H. Giddy
Financial Restructuring 18
Debt-Equity Swaps
Cosmetic or real?
 Choices for company under siege

Raise
new equity to pay off creditors
Example: Iridium
Give creditors equity in place of debt
Example: Sammi
Copyright ©2003 Ian H. Giddy
Financial Restructuring 19
What Do Debt-Equity Swaps Do?
Overleverage creates financial distress
Actual or potential default
Lenders take equity in lieu of repayment
Lenders hold equity passively
Lenders replace management
Change of control
means restructuring
Existing management buys time



Copyright ©2003 Ian H. Giddy
Lenders sell equity
Financial engineering
Bottom line “rationalization”
Divestitures & outsourcing
Financial Restructuring 20
What Are The Alternatives?

Key: Make the new securities attractive
to:
Existing
lenders
New lenders
New bond investors
New equity investors
Copyright ©2003 Ian H. Giddy
Financial Restructuring 21
The Financing Spectrum
Equity
Expected Return


Residual returns
after contractual
claims
Control through
voting rights
Senior Debt


Returns independent
of the value of the
business
Control through
covenants
Risk
Copyright ©2003 Ian H. Giddy
Financial Restructuring 22
The Financing Spectrum
Expected Return
Equity
Preferred equity
Convertible debt
Subordinated debt
Senior unsecured debt
Senior secured debt
Risk
Copyright ©2003 Ian H. Giddy
Financial Restructuring 23
The Financing Spectrum
Expected Return
Equity
Preferred equity
Convertible debt
Subordinated debt
Senior unsecured debt
Asian bank NPLs
Senior secured debt
Risk
Copyright ©2003 Ian H. Giddy
Financial Restructuring 24
What Are The Alternatives?
Asset-backed or cash flow-backed debt
 Senior debt
 Subordinated debt
 Subordinated debt with upside
participation
 Subordinated debt with equity option
 Preferred equity
 Restricted shares
 Common stock

Copyright ©2003 Ian H. Giddy
Financial Restructuring 25
Subordinated High Yield Debt






“Junk bonds” – like equity, but allow
increased financial leverage
Tax advantage over equity
Big market in USA (institutional investors) and
increasing in Europe
Leveraged loans favored by certain
commercial banks
Often used in connection with M&A and LBOs
Behave like equity – and often have equity
participation
Copyright ©2003 Ian H. Giddy
Financial Restructuring 26
Sub Debt -- Motivations
Optimization of financial leverage
 Regulatory-driven capital requirements
 Rated asset securitizations (senior-sub
structure in asset-backed securities)
 Insider or supplier-credit subordination
(eg in project finance)
 Work-outs and restructurings (existing
borrowers agree to seniority of new
loans, to buy time)

Copyright ©2003 Ian H. Giddy
Financial Restructuring 27
Sub Debt’s Big Problem: High Interest!
Solutions
 Deep discount subordinated debt
 Subordinated debt with equity warrants
 Convertible subordinated debt
 Participating subordinated debt
 Puttable subordinated debt
Copyright ©2003 Ian H. Giddy
Financial Restructuring 28
Preferred Equity
Legally a form of equity
 Claim senior to ordinary equity
 May have fixed dividend, or may be
“participating”
 But cannot trigger liquidation if payment
missed
 Par value determines liquidation claim

Copyright ©2003 Ian H. Giddy
Financial Restructuring 29
Convertible Preferred
Used by venture capital firms
 Permit investors to participate in growth
 But give preference in liquidation if the
venture fails
 And disguise share value (tax!)
 A variant – PERCS* give issuer right to
convert into common stock

*Preferred equity redemption cumulative stock
Copyright ©2003 Ian H. Giddy
Financial Restructuring 30
Preferred Stock: Pros and Cons
Advantages
 No dilution of control
 Dividends
conditional on
availability of
earnings
 Omission cannot
force liquidation
Copyright ©2003 Ian H. Giddy
Disadvantages
 Higher after-tax cost
than debt
 Lower return on
equity
 Limited investor
interest
Financial Restructuring 31
Restricted Stock: Pros and Cons
Advantages
 Overcome foreign
control restrictions
 Insiders retain
control
 If company well run,
value of control may
be low
Copyright ©2003 Ian H. Giddy
Disadvantages
 Nonvoting stock
trades at a discount
 Dual-class recaps
hurt stock price
 May allow
management to
avoid needed
reforms
Financial Restructuring 32
The New Equity Option
Key: Make the new equity attractive to:
 Portfolio investors

Domestic
International
Reduce
agency costs or we’ll “Just say
no!”

Strategic/direct investors
Domestic
International
Cede
Copyright ©2003 Ian H. Giddy
control or we’ll go elsewhere
Financial Restructuring 33
The Difference



“The Ministry of Finance received a preferred
share while investors received a preferred
share and a warrant allowing them to
purchase the ministry's share at a 13.3%
premium (equivalent to the cost of carry)
during a three-year period. The preferred
shares carry a 5.25% dividend and full voting
rights”
"When institutions started buying the story,
they bought the convertible bonds, the sub
debt - you name it, they bought it."
Alternatives: Thai Farmers Bank: SLIPS,
Bankok Bank: CAPs
Copyright ©2003 Ian H. Giddy
Financial Restructuring 34
Transparency and Disclosure


A 275-page prospectus, which provided a
breadth and depth of information previously
unseen in an Asian issue.
"We went and looked back at US bank
holding company offers - those that were US
SEC Grade 3 compliant. We also went
back and looked at a lot of the prospectuses
for the recaps of US banks, like Mellon and
Citibank. We looked at the level of disclosure
they achieved and committed ourselves to
exceeding that -- which SCB did."
Copyright ©2003 Ian H. Giddy
Financial Restructuring 35
What Globally Mobile Investors Look At
Macro
Factors
Structural
Factors
Firm-level
Factors
Copyright ©2003 Ian H. Giddy
• Currency overvaluation
• Capital restrictions
• Acctg & disclosure requirements
• IAS compliance
• Bankruptcy regime
• Creditor rights
• Govt-corporate nexus
• Trading infrastructure
• Price-Value ratio, Sharpe ratio, EVA
• D/E ratio
• Currency & maturity mismatch
• IAS conformity
• Insider control
• Objective research coverage
• Trading liquidity
Financial Restructuring 36
Fixing the Capital Structure:
Distress Restructuring
Cap des Biches (C)
The Creditors are Prowling
Trouble!
Reason
The financing
is bad
Business
mix is bad
The company
is bad
Remedy
Raise equity
or
Change debt mix
Sell some businesses
or assets
to pay down debt
Change control
or management
through M&A
Copyright ©2003 Ian H. Giddy
Financial Restructuring 38
Financially Distressed Firms
Lose customers
 Get less favorable terms from suppliers
 Are forced to discount products
 Reduce new investment to below the
optimal level
Example: Hynix (Korea)

Source: Altman (1984), Opler and Titman (1994)
Copyright ©2003 Ian H. Giddy
Financial Restructuring 39
When Default Threatens,
Value the Company
Highest Valuation of Company?
Merged Value
Sale to Strategic Buyer
Going Concern Value
Auction
Voluntary Reorganization
Existing Management
Copyright ©2003 Ian H. Giddy
Ch 11 Reorganization
Liquidation Value
Voluntary Liquidation
Ch 7
New Management
Financial Restructuring 40
Zombie, Inc
Does it make sense to dissolve the
company?
 Is it better to sell the company?
 How much debt can the company afford
to have?
 Assume you have been brought in as
the new CEO-CFO team. What terms of
restructuring can you propose to the
banks?

Copyright ©2003 Ian H. Giddy
Financial Restructuring 41
Debt Restructuring in Distress
Can a debt restructuring create value?
Assets
Operating
Cash
Flows
Copyright ©2003 Ian H. Giddy
Liabilities
Debt
Equity
Banks give
up some
creditor
rights in
exchange
for equity
Financial Restructuring 42
Example
Earnings at Zombie Inc., have suffered in recent years.
The private company now faces a financial crisis, as
a result of its possible inability to repay a principal
repayment on its debt coming due in the next
quarter.
The company's summary balance sheet is as follows:
Assets
Cash
Accounts receivable
Other short term assets
Property, plant and equipment
Total
Copyright ©2003 Ian H. Giddy
100000
900000
5100000
8000000
14100000
Liabilities
Accounts payable
Short term secured debt
Long term bank debt
Shareholders equity
Total
1000000
100000
9000000
4000000
14100000
Financial Restructuring 43
Example
The company faces a takeover, but management has
made a restructuring proposal to its unsecured bank
lenders, namely that they convert one half of
Zombie's bank debt into equity at the current book
value per share.
Should the banks take the offer?
Assets
Cash
Accounts receivable
Other short term assets
Property, plant and equipment
Total
Copyright ©2003 Ian H. Giddy
100000
900000
5100000
8000000
14100000
Liabilities
Accounts payable
Short term secured debt
Long term bank debt
Shareholders equity
Total
1000000
100000
4500000
8500000
14100000
Financial Restructuring 44
Example of Valuation:
Before-and-After
Zombie, Inc
Share Valuation
Shares
Book Value
Acquisition Value
Management Est.
NPV, based on
EBITDA
WACC
Growth
Debt
Going Concern Value
$
$
$
Before
400,000
10.00 $
8.00
20.00 $
After
850,000
10.00
9.41
1,100,000
1,100,000
17.48%
11.22%
2.5%
2.5%
10,100,000
5,600,000
$
(6.43) $
8.62
Option value?
Bank lenders
Debt (at market)
Equity (NPV value)
Total
Copyright ©2003 Ian H. Giddy
Before
7,182,749
0
7,182,749
After
4,500,000
3,876,905
8,376,905
Financial Restructuring 45
Cap des Biches (C)

CDB, two years after the successful
LBO, is having difficulty meeting its debt
service obligations. The banks are
putting pressure on management to
make a restructuring proposal.
 Can
Cap des Biches afford to pay its required
interest and principal this year? Next year?
 What is the debt capacity of Cap des Biches
Power Company?
 Please suggest a way in which the debt could be
restructured to keep the banks satisfied and keep
the company alive.
Copyright ©2003 Ian H. Giddy
Financial Restructuring 46
Fixing the Capital Structure:
Making Use of Cash Flows
Leveraged Finance
Company
has
unused
debt
capacity
Copyright ©2003 Ian H. Giddy

Takeover?

Share buyback?

Leveraged
recapitalization?
Financial Restructuring 48
Leveraged Recapitalization
Strategy where a company takes on
significant additional debt with the
purpose of paying a large dividend (or
repurchasing shares)
 Result is a far more leveraged company
-- usually in excess of the "optimal" debt
capacity
 After the large dividend has been paid,
the market value of the shares will drop.

Copyright ©2003 Ian H. Giddy
Financial Restructuring 49
Leveraged Recapitalizations

Motivations:
Defensive
Proactive
Ownership

transition/liquidity
Which produces what value?
Copyright ©2003 Ian H. Giddy
Financial Restructuring 50
Cap des Biches (D)
CDB, after its debt restructuring, has
achieved a turnaround. Net cash flows
are now positive and steady, and the
shareholders are looking for ways in
which they can realize the benefits of
their investments.
 Should they pay a dividend, buy back
shares, or sell the company?

Group report due by Wednesday 11th June
Copyright ©2003 Ian H. Giddy
Financial Restructuring 51
What is Corporate Restructuring?
Any substantial change in a company’s
financial structure, or ownership or
control, or business portfolio.
 Designed to increase the value of the
firm
Restructuring

Improve
capitalization
Copyright ©2003 Ian H. Giddy
Improve
debt composition
Change ownership
and control
Financial Restructuring 52
Copyright ©2003 Ian H. Giddy
Financial Restructuring 53